What is Private Equity? A Brief History

An Introduction Into the World of Private Equity

Private equity is, in the most simplistic terms, equity held in a private business. PE firms are run by general partners (also called sponsors). GPs invest money raised from investors who work together for a limited amount of time, aptly named “limited partners.”

PE by Another Name: The Leveraged Buyout

Private equity firms are sometimes referred to as “buyout firms.” This is so for a few reasons. First, the term is descriptive. Unlike venture capital firms, which usually don’t buy entire companies, PE firms do–or at least they acquire controlling interests in certain operational or management decisions. Second, the term is actually shorthand for “leveraged buyout firm.” Most PE buyouts involve a PE firm putting up only a portion of the capital required to purchase a target, with the remainder coming in the form of a loan from a bank that is secured by the assets of the acquisition target. These loans secured against the acquired company’s own assets are the “leverage” in a leveraged buyout (LBO).

Leveraged buyout firms established themselves on Wall Street in the late 1970s and 1980s when investment bankers, like notably high-profile financier Michael Milken, created them as a method of leveraging a company with debt equity and equity capital in order to buy it. Among the most notorious buyout firms of that period—although not connected to Milken—was the $25 billion RJR Nabisco buyout in 1988. In many ways, today’s PE firm is yesterday’s LBO firm.

Once purchased, the target company is usually one of many owned, or at least controlled, by the PE firm and, thus, is typically referred to as a “portfolio company” of the firm.

Private Equity Funds vs Private Equity Firms

One point of clarification: above, we speak of a private equity “firm.” We were intentionally imprecise in order to more clearly present the following concept. One must delineate between a private equity firm and a private equity fund. The ‘sponsor’ is the PE firm, and the firm is often the general partner of several (or many) individual PE funds.

A limited partner (i.e., an individual accredited investor who decides to invest money with the PE firm) does so by investing in a specific PE fund raised by the PE firm. So, by example, a PE firm could have, say, four distinct funds of which it is the general partner and manager. Each fund will have its own limited partners (though any individual limited partner may choose to invest in multiple funds) and its own portfolio companies. Limited partners are not limited to individual accredited investors. Most count banks, insurance companies, pension funds and other large entities among their investors.

Private Equity is Not a New Concept

Taking a step back, the practice of people pooling their money together to purchase controlling stakes in a private company is not a new concept; although, as the Wall Street Journal points out in its excellent article on this subject, “[w]hile the private-equity firm is new, its methods—venture capital, growth capital, distressed situations, leveraged buyouts and others—are as old as capitalism itself.” In fact, the Massachusetts Bay Company was an early prototype of the private equity model, in that it pooled money to help fund the burgeoning British North American colonies. Settlers sent to the new American colonies helped build up the economy, while those who stayed in England helped fund the venture, hoping to find a return on their investment over time.

A few hundred years later, railroads were struggling to find funding by simply turning to wealthy families, as they had in the past. They were bailed out by major banks that bought controlling interests and used their leverage to restructure business operations, insert new management and attempt to eliminate corruption and deceit. These are all present-day components of private equity’s modus operandi. When JP Morgan & Company paid $480 million for floundering Carnegie Steel in 1901, it created what was the largest company in the world at that time: United States Steel.

So, why is private equity private? As discussed above, it tends to invest in private companies. But, this is not the answer, since one private equity strategy involves taking publicly-owned targets off the public market, “taking them private”. Private equity is private because it raises money in such a way (e.g., from accredited investors) that allows it to avoid having to make any public offering of a stock on a public stock exchange.

Today’s Private Equity Firm

The private equity firm of today traces its origins to the American Research and Development Corporation, founded in 1946. The industry also had forerunners in the form of U.S. governmental institutions created to address needs brought on by the two world wars and the intervening Great Depression, as explained by Wiley Finance in its 2008 book Private Equity, History, Governance, and Operations.

According to PEI Media, “[a]s recently as the 1970s, it was hard to count more than a few dozen private equity firms…in the United States. Now there are private equity firms both miniscule and enormous in all the developed countries of the world and in most of the emerging markets.” This development, as also explained in Characteristics of the Private Equity Arena, was in part a function of: (a) the U.S. stock market’s slump of the 1970s turning around; (b) clarifications in 1978 to ERISA, a 1974 law governing how retirement plan funds can be invested that was a drag on the industry before the clarification; and (c) subsequent reductions of the maximum capital gains tax rate.

The Golden Age of Private Equity

The golden age of the leveraged buyout firm came in the late 1980s when players like KKR and Michael Milken engineered large LBOs. Since then, as superior returns encouraged more investment in the asset class and as the number of funds proliferated as a natural consequence of fund managers leaving one firm to found a new one, the industry continued to grow into what it is today. A good example of this can be seen by looking at the legendary PE firm, Golder Thoma & Co.

Established in 1980 by Stanley Golder and Carl Thoma, Golder Thoma & Co. originated the “consolidation” or “buy and build” investment strategy, which sought to combine the best of venture investing with the best of leveraged buyouts by investing in a “platform” business in a fragmented industry, then working with management to transform it into a larger and more profitable business through internal growth and a series of strategic, industry-consolidating acquisitions.

Stanley Golder and Carl Thoma worked together at First Chicago Corp. before founding Golder Thoma & Co. Looking at one branch of the genealogy, Golder Thoma & Co. eventually split into Thoma Bravo and GTCR. Looking at a different branch, John Canning took Stanley Golder’s place at First Chicago Corp., and Canning ultimately left to form Madison Dearborn. These three firms are among the largest and most prominent PE firms currently in existence, though First Chicago Corp. later merged with Banc One Corp., now part of Chase Bank.